Worker Misclassification Guide: Independent Contractor or Employee?
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In 2016, Uber reminded companies about the danger of employee misclassification. Uber faced a class-action lawsuit, alleging that it misclassified thousands of drivers from California and Massachusetts as independent contractors.
Uber isn’t the only company that has been accused of assigning contractor status to workers who better fit the definition of employees. There’s a term for that: worker misclassification (also called employee misclassification or independent contractor misclassification).
Worker misclassification is an issue because businesses owe more protections and benefits to employees than contractors. Some companies try to cut costs by compensating employees as independent contractors, which are less expensive. But the legal and financial penalties of worker misclassification are not worth the risk.
We’ll walk you through the definitions of contractors and employees, the risks of worker misclassification, and how to classify your team correctly.
What is independent contractor misclassification?
Independent contractor misclassification is the illegal practice of categorizing workers as independent contractors when they are entitled to employee status, benefits, and protections. Worker classification hinges on factors like a worker’s financial relationship with a company and the degree of flexibility and control over the work.
Worker misclassification is often an intentional attempt at tax evasion, which results in hefty penalties. Companies sometimes misclassify workers unknowingly, which may lead to milder consequences.
Why do governments care about employee misclassification?
Government agencies like the Internal Revenue Service (IRS), the Department of Labor (DOL), and state governments created classification laws to protect both the government and employees.
Misclassification is a form of worker exploitation
The primary damage of misclassification is that workers who fit employee criteria can’t enjoy employee rights if the employer classifies them as contractors.
Contractors don’t have major employee protections, such as the right to collectively organize, guaranteed by the National Labor Relations Act. Other employee rights and protections include:
- Minimum wage
- Partially paid medicare and social security taxes
- Unemployment benefits
- Pension plans
- Hour laws
- Rest breaks
Independent contractors don’t have these rights because they have much more independence and flexibility than employees. When workers don’t enjoy the flexibility of independent contracting or the rights and compensation of employees, their company is exploiting them via misclassification.
Misclassification leads to loss of public tax revenue
When employers misclassify their workers, they avoid federal and state taxes, such as unemployment taxes and medicare taxes. Avoiding these taxes leads to a substantial loss of tax revenue, measured in billions of dollars each year.
Misclassification leads to unfair competition
Employers pay much more for employees than for independent contractors because of the benefits and payroll taxes they sponsor for each employee. Companies that misclassify employees as contractors may have an unfair advantage compared to employers who categorize their workers as employees as their total labor costs are lower.
Employees vs. independent contractors: what's the difference?
The difference between an employee and a contractor comes down to the working relationship with the company, employer responsibilities, payment methods, and a few other factors.
Type of relationship
Employees of a company typically work for a single employer on that employer’s payroll. The employer pays payroll taxes on the employees’ salaries.
Independent contractors are self-employed, often work for multiple clients at a time, and send invoices to get paid. They pay their own income tax and self-employment taxes because they aren’t on the company’s payroll.
Control over the work
Employers directly supervise their employees’ work and control what tools, equipment, and workflows they’ll use. Employees aren’t necessarily micromanaged, but they usually receive some guidance regarding tasks, processes, and priorities from one day to the next.
Independent contractors choose their own tools and decide how they will complete the work. They are responsible for delivering work on time and according to an agreed standard. Outside of that, they have complete control.
Work hours and oversight
Employees typically have a fixed working schedule, a manager, check-ins, and performance reviews. They are members of the team.
Independent contractors choose when they’re going to work. They may receive feedback about the end deliverable but should not receive ongoing management or oversight. They are more of a service provider than a part of the team.
Expertise and training
Employees receive training from their employers during onboarding and beyond. Most employees expect (and receive) long-term career development from their employer.
Independent contractors do not receive onboarding, training, or career development from companies. They pay for their own training and skill development, but they provide instant expertise to those who hire them.
Deadlines and deliverables
Employees may have deadlines for tasks their supervisor assigns, but they’re not contractually obligated to deliver certain tasks by a certain date.
Independent contractors have contracts that specify what to deliver and when. If they are late, they risk not getting paid.
Entitlements to benefits
According to the employment law, employees are entitled to statutory benefits under the Fair Labor Standards Act (FLSA). These benefits include:
- Unemployment insurance
- Workers’ compensation insurance
- Sick leave
- Overtime pay
- Employer contributions to medicare tax
- Employer contributions to social security taxes
Independent contractors don’t receive these employee benefits from their clients.
Employees get paid automatically every pay period, whether it’s weekly, bi-weekly, or monthly via company payroll.
Independent contractors need to send their clients invoices to get paid based on the payment terms from the independent contractor agreement.
Tax forms and obligations
In case you hire foreign independent contractors, you need Form W-8BEN/W-8BEN-E, depending on whether they do the work as individuals or business entities.
Read more in detail about the difference between employees and independent contractors in our ultimate guide.
Additional misclassification protections from US state agencies
The Internal Revenue Service (IRS) established a set of rules regarding employee misclassification that apply country-wide. However, state governments have also come up with their own ways of classifying employees. Here are some notable state laws.
California: AB 5 and Prop 22
California’s Assembly Bill 5 (AB5) extended employee status to companies employing gig workers in large numbers, such as Uber or Lyft. In November 2020, Prop 22 allowed employers to exempt app-based drivers from this regulation and still treat them as contractors. But Prop 22 was declared unconstitutional in 2021, meaning companies must treat these gig workers as employees.
New York: Freelance Isn't Free
New York’s Establishing Protections for Freelance Workers Act took a different approach. Rather than forcing companies to classify certain workers as employees, it provided additional rights to contractors. These rights include required written contracts for freelance projects, protection from retaliation, and timely and full payments.
Companies that hire independent contractors can’t create waivers to limit their rights or include a provision that stops workers from discussing their contracts with governing bodies.
New Jersey: New laws to identify and penalize misclassification
In July 2021, New Jersey voted on a new law with a goal to prevent employee misclassification. The new regulations facilitate the identification of employers who categorize employees as contractors and penalize them. The state also created the Office of Strategic Enforcement and Compliance under the new law, as a part of the Department of Labor and Workforce Development focused on misclassification of workers.
How to avoid misclassification risks
Intentional misclassification isn’t the only danger. Companies that hire independent contractors, especially under long contracts, must be proactive about proper classification.
Create thorough independent contractor agreements
A good agreement documents the specific reasons the worker is an independent contractor and not an employee.
It’s possible to work with a contractor based on a verbal agreement, but it’s highly recommended to write up an independent contractor agreement. A written contract will set clearer expectations between the company and the contractor. It will also serve as a legal document should an employee classification, intellectual property, or non-disclosure issue arise.
If you treat the worker as an employee, this document won’t hold up, but it’s a good first line of defense.
Use employment services
If you delegate the hiring process to an employer of record’s employment services, you can rely on their team of professionals to know the laws and classify your workers correctly, no matter where you hire.
Run regular misclassification audits
If you run a small business and work with independent contractors, run employee classification audits at least once a year. Reviewing your workers’ status will help you make sure your independent contractors aren’t drifting toward employee status.
Use the five methods below to evaluate your working relationships with people on your team.
5 ways to determine worker status
Different local, state, and federal government agencies provide employers with classification tests to categorize workers correctly.
Reasonable basis test
According to the reasonable basis test, you can categorize your workers as independent contractors if there’s a reasonable basis for such a decision. This test gives a general baseline based on how the IRS looks at workers in similar situations rather than the specific relationship between you and your workers.
Some of the reasonable bases that justify a worker’s independent contractor status are:
- Past IRS audits that didn’t discover any irregularities in your worker classification
- Previous official consultation with a CPA or an attorney
- Workers in similar situations considered independent contractors across your industry
Read more about this test here.
IRS's 20-factor or common law test
The IRS 20-factor or common law test consists of 20 questions divided into three main categories: behavioral control, financial control, and nature of the relationship.
Although outdated, this test is very thorough and covers many aspects of the employer-worker relationship. The common law test examines:
- Whether the employer controls where, when, and how the worker completes their work
- Whether the employer provides the worker with training, tools, and equipment
- Whether the worker has multiple clients or works for a single employer
- Whether the employer reimburses the worker’s business expenses, and more.
If the employer controls most of these business relationship aspects, the worker is probably an employee.
You can see the full list of questions here.
Department of Labor's Economic Reality test
The US Department of Labor (DOL) has a multi-factor test to determine a worker’s status based on their financial dependence on an employer. Unlike full-time employees, independent contractors are self-employed individuals whose livelihood doesn’t depend on a sole employer. If their livelihood depends on a single employer, they are probably employees.
The DOL’s test, among other factors, questions if:
- The worker’s services are a core business activity for the employer
- The relationship between the worker and the employer is permanent
- The worker needs to invest in facilities and equipment to perform the job
- The worker has opportunities for profit and loss
Read more about DOL’s test here.
The ABC test
Codified by the California Supreme Court, the ABC test is a common way to determine a worker’s status across the US. It uses three critical elements of a business relationship to determine that an independent contractor is not an employee.
To be considered an independent contractor, a worker must:
- Be free to organize their own working hours and methods of work
- Do the same type of work for other client companies
- Do work outside of the client’s regular business activities
Learn more about this test here.
IRS Form SS-8 allows individuals and companies to request the IRS conduct an audit and officially determine a worker’s status.
An employer can submit this form if they’re not sure how to classify their workers, but workers are also entitled to turn to the IRS for help if they believe their employer misclassified them.
Download our interactive worker classification tests to determine if everyone on your team has the correct employment status.
Use Form 3949-A to report a business for misclassification
IRS Form 3949-A collects information about an individual or a business you suspect has violated tax laws by not withholding taxes from your paycheck, not paying taxes, not reporting income, etc.
Misclassified workers can use this form to report an employer if they believe they should be employees. They can report both a business and the owner.
Penalties for employee misclassification
The consequences of misclassifying your workers range from monetary penalties to jail time, depending on whether you’ve breached the law knowingly or unintentionally.
- Tax violation fines, which include $50 per each W-2 tax form you didn’t file and a percentage of the misclassified employees’ wages and FICA taxes
- Payment penalties up to $1,000 per misclassified worker
- Employee benefits insurance repayment
- Class action lawsuits
- Wage claim audits
- Punitive damages
- Jail time
Myths about misclassification
Education is key to prevent the misclassification of employees. Here, we debunk a few common myths regarding worker classification.
Independent contractors don't qualify for social security, medicare, or unemployment insurance
Independent contractors qualify for social security, medicare, unemployment and health insurance. The only difference is that independent contractors pay for these taxes by themselves. However, they may get a tax deduction for the employer’s portion of the FICA benefits.
Employers decide worker status
Employers are responsible for giving a worker’s status based on government descriptions. If the employer makes a mistake, they are liable and may face a penalty.
Employers make mistakes. They might put workers on payroll even if they’re actually independent contractors, or classify them as 1099 workers even if they should be employees. The government makes final determinations on a worker’s status.
Workers who start as independent contractors must stay that way
An independent contractor may become an employee within the same company. Usually, this happens if the client decides to extend an offer or if the company realizes their relationship starts to resemble employment. A worker’s status can also change when they switch companies.
Part-time workers are independent contractors
Employees can work for you part-time or full-time. If they’re guaranteed an hourly wage or a salary, they’re not independent contractors, especially if your working relationship is ongoing.
Remote workers are independent contractors
Remote workers may be independent contractors, but they may also be employees. A company can hire full-time employees and allow them to work remotely, or hire from other countries through subsidiaries or employers of record. They can also hire remote independent contractors for different purposes, for example, if they have an extra workload to cover.
Statutory employee: a (rare) third worker classification
Statutory employees make the third category of workers that includes employees who act as a separate business from the hiring company, but the IRS considers them employees for tax purposes.
This worker classification is very rare. The IRS names only four categories of workers who can be statutory employees:
- Drivers in charge of trucking and distributing meat, beverage, fruit, vegetable, or bakery goods; or in charge of picking up and delivering laundry and dry cleaning
- Insurance sales agents who work for a single employer whose primary business activity is selling insurance
- Full-time salespeople who sell your merchandise to buyers such as hotels, restaurants, retailers, as their primary business activity
- Piece workers who work at home on the material or goods you provide and that must be returned to you when completed
Hire compliantly around the globe with Deel
Compliance is a complex matter, even more if you hire globally. Each company has unique labor laws regarding the difference between employees and independent contractors. If you hire a worker from another country, you have to understand and comply with international misclassification law.
Deel can figure this out for you.
Deel helps you hire full-time employees and engage with contractors worldwide under locally compliant contracts so you don’t need to worry about a thing. Minimum wages, statutory benefits, payroll taxes–we take care of it all.
Want to learn more about what it looks like in practice? Schedule a call with an expert from our team.
This post is provided for informational purposes and should not be considered legal advice. Talk to a legal professional such as an employment lawyer for more info.